How to Capitalize on the Collapsing VIX

What to do about the VIX? That’s the question on traders’ minds after the volatility index plunged 1.11 points to 12.46 on Friday, bringing it to a level last seen in mid-2007.

The collapsing VIX took the volatility exchange-traded products (ETPs) along for the ride, adding to the already massive losses they suffered in 2012. The Barclays iPath S&P 500 VIX Short-Term Futures ETN (NYSE:VXX[1]) slid 6.4%, while the notorious VelocityShares Daily 2x VIX Short Term ETN (NYSE:TVIX[2]) lost 11.3%.

This may seem like the makings of an opportunity, but investors need to watch where they tread before getting too excited about betting on a reversal in the VIX.

First, it pays to take a step back and look at the current VIX from a historical perspective. Friday’s 12.46 reading is extremely low compared to the levels we’ve become used to in recent years, but a sub-13 VIX does have historical precedent. The index spent much of the 2005-2007 period in the 10-13 range, and it even closed in the 9s on three days in November-December 2006.

Further, the drop in the VIX comes at a time in which the majority of “known unknowns” have been taken off the table as potential issues. With the concerns about U.S. fiscal policy and the problems in Europe and the Middle East largely removed from the equation, the market’s low realized volatility is exerting a downward pull on the index.

As a result, it’s important not to jump too quickly to make a contrarian trade on the VIX. This is absolutely a case where Peter Lynch’s warning about the phrase “If it’s gone down this much already, it can’t go much lower” is worth keeping in mind.

Weighing the Choices

Having said this, no doubt some investors are looking to capitalize on a VIX in the 12s. There are plenty of ways to play the VIX directly, but most of them are flawed. At first glance, the most obvious choice is long-VIX ETPs such as VXX or double-long products like TVIX and ProShares Ultra VIX Short-Term Futures ETF (NYSE:UVXY[3]). Of course, the well-documented problem[4] is that the value of these products is perpetually being eroded by their need to “roll” into later contracts at higher prices since the VIX curve tends to be upward sloping.

While always an issue, the problem particularly acute now since the VIX curve[5] is steep. While the spot (January) VIX closed at 12.46 on Friday, the February and March contracts closed at 14.65 and 16.28, respectively. The upshot for the trader in VXX and its ilk is that the VIX needs to turn higher within a few days of making the trade, or this erosion starts to come into play.

In short, you not only have to be right, but you have to be right right now.

An even worse play on the VIX is to buy call options on ETPs such as VXX, TVIX or Barclays iPath S&P 500 VIX Mid-Term Futures ETN (NYSE:VXZ[6]). Think about the absurdity of such a trade: buying a security with built-in time decay (the option) that’s based on an asset that itself decays over time due to the negative roll. It should go without saying that this trade should be avoided at all costs.

Instead, Consider This:

While volatility ETPs are a minefield for the unwary investor, a more sensible approach is this: Consider taking advantage of the low VIX by buying portfolio protection at very inexpensive levels. Despite the steep volatility curve, even longer-dated options are on sale after the downturn in implied volatilities in the past few days.

This is a rare lull in the constant stream of adverse headlines we’ve witnessed in recent years. Don’t bet on it lasting forever.

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Editor’s note: This column has been updated to remove an erroneous section about the benefit of shorting short ETPs. InvestorPlace.com regrets the error.